The Divergent Trading Strategy

Divergence in the stock market is an early signal of the market behavior soon to come. The divergence indicates a change in direction, disagreement, discrepancy, and deviation. Therefore, analysis of the market on the basis of the divergence requires identifying inconsistencies in the direction of movement of the indicator and the direction of price movement.

In trading, the divergence refers to a situation in which price indications and the corresponding indicator visually diverge. It occurs when a higher peak on the price chart is not confirmed by the relevant figure on the indicator chart.

Classification And Conditions For The Occurrence Of Divergence

A bearish divergence is a situation that arises on an uptrend when the price shows a higher peak. On the contrary, the indicator indicates a lower one. It is a signal for a potential downward price reversal. Bullish divergence (convergence) is a similar situation on a downtrend when a lower peak of the indicator corresponds to a lower price peak. This movement is a signal to turn up.

Use the MACD and RSI indicators to identify the divergences. In practice, a significant divergence, which correctly signals a reversal of the market, contains many small deviations. They seem to be initially insignificant, but over time acquire specific significance.

The difficulty lies in the need to understand which of the divergences is of greater importance to give it proper attention. One of the ways to define a false deviation in the stock market is to determine the trend of the market. For this purpose, appropriate indicators are used. For example, traders use linear regression or the method of simple observation of the price chart.

Examples of stock market divergence

The following conditions must be met under bearish divergence:

  • On the price chart, at least two high highs in a row formed, the second of which is higher than the first. There can be more than two peaks, as long as each subsequent one is not lower than the previous one.
  • At the same time, the oscillator loses its maxima in such a way that each subsequent one is not higher than the previous one.

Figure 1. Bearish divergence example

For different frames and tools, different periods of indicators will be optimal. The trader should manually test different options and set up such parameters, which determine more working divergences on each instrument.

Which time-frame is better to use? In general, the higher the timeline – the better. For periods of less than H1, you can only navigate if you trade within a day. However, you should pay attention to a higher time-frame if divergence is confirmed by the higher timeline, the chance it being processed increase.  

Divergence predicts a possible trend reversal on a frame-specific scale, rather than the entire market. If most indicators of the lower time-frame show it, and the higher time-frame does not, then the price is going to be adjusted on the scale of the lower time-frame, but the overall trend remains strong.

Thanks for reading!

-The TMP Team

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